Tuesday, September 10, 2019

The Three Rules of Freemium

At the SaaStr Europa conference in Paris a couple of weeks ago I sat down with Joaquim Lecha, the CEO of our portfolio company Typeform, to talk about “Freemium at Scale”. Founded and headquartered in Barcelona, the company launched a free version of its service seven years ago. During our conversation Joaquim revealed that this free service helps drive 180,000 monthly signups, and about 3% of those signups convert into paying users who are billed anywhere from €25 to €70 per month, depending on the plan they choose. In other words, Typeform is effectively leveraging a free version of its product to drive paid subscriptions at scale.

I have a bit of a love/hate relationship with the freemium model. Done right, freemium can lead to amazing success. One of the best examples is Dropbox, which Tomasz Tunguz called the “King of Freemium”. What makes the company unique, he argues, is how it transformed its free users into evangelists. “Unlike other SaaS companies, Dropbox spends more of its revenue on engineering than sales and marketing,” Tomasz wrote. “Typically, businesses spend twice as much on S&M.” In a piece I wrote when Dropbox went public last year, I pointed to the section of the company’s S1 that detailed how Dropbox drove sales of its enterprise solutions. Unlike most other enterprise software, which traditionally used to be chosen by the IT department, Dropbox is typically adopted by individual employees from various departments, who then lobby management into switching. As I noted in my piece, Dropbox was one of the early champions of the ‘consumerization of enterprise software’ movement, which was one of the strongest drivers of SaaS success in the last ten years.

But not every SaaS company can be a Dropbox or a Typeform. Done wrong, freemium can end up cannibalizing your paid user base while also draining your company’s precious engineering and customer support resources. So how do you know if launching a freemium product is the right move for your company?

Let’s discuss some of the pros and cons of the freemium model.

The downsides of freemium

I think many SaaS companies are too optimistic in thinking that they can just offer a free, pared-down version of their software and that this will result in a wave of user signups followed by increased revenue once those users make their way down the purchase funnel. But there are a number of factors you should consider first:

Added costs: Given that SaaS is an extremely high-gross-margin business, one might think that you can easily support free users. However, even if your gross margin from paying customers is 80% to 90% (i.e. your CoGS are only 10% to 20%), those costs can become very significant if you grow a large user base that doesn’t generate any revenue.

From engineering to hosting, the freemium model will require consistent upkeep that drains resources that would be otherwise devoted to your paying customers. And even though your freemium users won’t be paying a dime, they will still expect some level of customer service. In our discussion at SaaStr Europa, Joaquim revealed that, on average, 70% of Typeform’s support tickets come from free users and that the company spends $130,000 per month supporting them.

Now, Joaquim didn’t consider this too high a price to pay for the various benefits of having a free plan (more on that below), but for other companies, the upside/downside assessment may look different. If your business has lower-than-usual gross margins (e.g. because your SaaS solution includes a service component or because your product is particularly costly in terms of infrastructure), you should think extra hard about whether freemium is right for you.

Cannibalization of paying users: For any freemium model, the running assumption is that a certain percentage of non-paying users will eventually convert into paying customers. But what should also be considered is how usage will flow the other way. In other words, some people, who without a free plan would have become paying customers, will be fine with the free plan and won’t need the paid version.

An imbalance of product features: A freemium approach requires a delicate balance. Provide too many features for free and you risk cannibalizing your paid user base. Offer too few features and you eliminate the value proposition for users to sign up in the first place. Typeform walks this tightrope well, limiting its free surveys to 10 questions and 100 responses. Converting to the paid version grants the user unlimited questions and responses, as well as advanced features such as logic jumps and design personalization options. Not every SaaS company can strike that kind of balance.

Less focus on core users: An important factor to keep in mind is that having a freemium model will almost inevitably have a strong impact on your product roadmap. If you have a free plan, chances are that for every paying customer you’ll have 10–20 (or more) non-paying users. It’s hard to ignore the feedback of a group of users that represents 90–95% of your total user base. Listening to those users doesn’t have to be a bad thing, but it may. It all depends on how similar your non-paying users and their use cases are to your paying customers. In this interesting analysis about the “rise, fall, and future of Evernote” — once the poster child of freemium — Patrick Campbell and Hiten Shah conclude that “trying to appeal to everyone and not building the functionality that core customers want to use made Evernote’s product feel stagnant, which is definitely a tradeoff they should never have made.”

Widening the top of the funnel also makes it critical that you are excellent at identifying the best leads effectively and efficiently. If you don’t do that, your valuable signups might fall through the cracks in all the noise.

The benefits of freemium

Most of the above challenges can be overcome if your free plan leads to a much larger top of the funnel and if you can convert enough free users into paid. A freemium model will likely lead to a lower conversion rate, but that’s OK if it’s more-than-offset by the increase in signups. Assuming that you can keep conversions at a sustainable level, then the freemium model can have several benefits:

More active users: One of the biggest challenges that SaaS companies face is driving adoption of their product. And while some users can be enticed by a free trial period, there’s a subset of consumers who are just more likely to keep using the product if it’s free. Others won’t even sign up in the first place if there’s no free plan.

More evangelists and a positive impact on your brand: You shouldn’t measure a user’s worth solely on whether they eventually start paying you. The larger the number of active users, the greater the pool of potential evangelists who will promote your product to new users. In my discussion with Joaquim, he told me that users who were aware of Typeform’s brand prior to signing up were twice as likely to convert into paid users than those who came in via non-organic channels. Qwilr, another Point Nine portfolio company, has made the same observation.

Amplify virality: The strongest rationale for going freemium is having a product with a built-in viral loop (like Typeform or Dropbox). If you’d like to dig deeper into viral growth in SaaS, check out this great post by my colleague, Louis. One caveat I’d add is that you can’t take it for granted that your free users will have the same viral coefficient (or k-factor) as your paid users. In many cases, your average free user will be less active than your average paying user and will therefore lead to fewer referrals. It doesn’t have to be like that, though. In an ideal world your paywall is built in such a way that users have an unlimited ability to share (or do whatever it is that makes your product viral) and monetize something else.

More user feedback: In our talk, Joaquim pointed out another advantage of having a large user base: It allows Typeform to learn from a much larger number of people. That’s a very interesting aspect that I hadn’t thought about before. Keep in mind, though, that as mentioned further up, depending on your product and industry, feedback from free users may be more or less relevant.

Re-engaging trial users: Every SaaS company will have a certain subset of users who will sign up for a free trial of the paid product and will not convert into a paying user once the trial period ends. Introducing a freemium version allows you to re-engage these users with the possibility of converting them at a later date.

Making the decision

So now that we’ve looked at the potential upsides and risks, how can you decide whether launching a freemium product is the right choice for your company?

Ultimately, only an A/B test can answer this question. However, getting reliable results will take a lot of time, especially if you want to measure the impact on virality and if you have a viral cycle time of, say, six months. If you can’t wait that long (or if you’re not equipped to do a complete-funnel A/B test), here are my “Three Rules of Freemium”:

1) Does your paid plan have a gross margin of 80–90%?
If you have a lower gross margin — for example, because your product is not fully self-service, requires extensive customer support or is extremely costly in terms of tech infrastructure — freemium will probably not work for you.

2) Does your free plan attract the right audience?
If your free users are too different from your paying users, your free-to-paying conversion will be low — and you’ll risk developing your product for the wrong audience.

3) Is your product inherently viral?
If your answer is no, that doesn’t make it a complete no-go, but it does mean that it’s much less likely that freemium is right for you.

Wrapping up

In the end, freemium only makes sense if a certain percentage of your free users do one of three things: 1) Eventually convert to paid, 2) refer paying customers, or 3) provide the kind of valuable feedback that will improve your product. A freemium product that fails to achieve any of these effects will merely saddle you with extra costs and distract you from servicing your most important users. Not every company can be a Dropbox, but the good news is that not every SaaS company needs to adopt Dropbox’s freemium model to succeed.